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AEM 4550: Economics of Advertising Prof. Jura Liaukonyte


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Title: AEM 4550: Economics of Advertising Prof. Jura Liaukonyte

  • AEM 4550 Economics of Advertising Prof. Jura

Lecture Plan
  • HW2
  • Exam 1
  • Informative View
  • Memory Jamming View
  • Empirical Studies of Advertising Effectiveness
  • Advertising and Media Planning
  • Definitions
  • Costs
  • Upfront Market

Model of Advertising as Information
Example Auto Industry
  • Interaction between Persuasive and Informative

Manufacturers vs Dealers
  • Brand Advertising advertising geared towards
    brand positioning and communication of product
    attributes and brand benefits
  • Price Advertising advertising that informs
    consumers about price and availability of a brand

Manufacturers vs Dealers
  • Manufacturers often use brand advertising
  • Ex Ford Tough or V-8 Engine
  • Dealers often use price advertising
  • Ex 2,000 rebate or Labor Day Sales Event

Manufacturers vs Dealers
  • Manufacturer Brand Advertising (MBA) and Dealers
    Price Advertising (DPA) interact positively
  • This suggests that brand advertising and price
    advertising may work together when they are sent
    by different channel members
  • Attribution Theory when consumers accredit auto
    dealers discount advertisements to addressing
    competition in the industry, the price
    advertising increases purchase intent.

Manufacturers vs Dealers
  • Manufacturer Brand Advertising (MBA) and
    Manufacturer Price Advertising (MPA) interact
  • This suggests that brand advertising and price
    advertising do not complement each other when
    they come from the same channel.
  • Unlike Dealers Price Advertising, when
    manufacturers use price advertising, consumers
    connect a lower price to a defect in the product.
  • This is consistent with the informative view of
    advertising because advertising about price makes
    demand more elastic.

Manufacturers vs Dealers
  • When Dealers advertise about price, it increases
    consumers intent to purchase.
  • When manufacturers advertise about price, it
    decreases consumers intent to purchase.

Manufacturers vs Dealers
  • As a result, brand advertisements by
    manufacturers and price advertisements by dealers
    should be coordinated to appear at similar times.

Empirical evidence Setting
  • In the 1960s, considerable variation existed
    across US with respect to the legal treatment of
    advertising in the eyeglass industry
  • Some states prohibited all advertising
  • Some states prohibited price advertising but
    allowed non-price advertising
  • Some states had no restrictions
  • This variation provides a natural experiment

Empirical Evidence
  • Eyeglass prices were substantially higher in
    states that prohibited all advertising than in
    states that had no restrictions
  • The association between price advertising and
    lower prices is striking and directly supports
    the informative view

Other Studies
  • Cady (1976) considers the U.S. retail market for
    prescription drugs in 1970
  • Retail prices are significantly and positively
    related to advertising restrictions
  • Maurizi and Kelly (1978) compare retail gasoline
    prices across major cities
  • Both the mean and variance of prices are lower in
    states where price advertising is allowed
  • Schroeter, Smith and Cox (1987) use survey data
    for the routine legal service market in 17 U.S.
    metropolitan areas
  • Evidence that pricecost ratios are lower when
    area-wide advertising intensity is greater
  • These studies all support the informative view

  • Persuasive/Complementary Model
  • Higher advertising leads to higher demand for
    each consumer, which leads to higher prices.
  • Informative Model
  • Higher levels of advertising leads to more
    consumers but not a higher demand for each
    consumer, so prices are not affected by
    advertising levels.

Signaling as Information
  • For experience goods, advertising can also be
    used to signal quality.
  • If a company engages in an expensive ad campaign,
    you might infer that the good is high quality
    because only high quality firms could afford the
  • Price is can also be used as a signal of high

Signaling as Information
  • Nelson, 1970 begins with a simple question
  • How, exactly, does advertising provide
    information to consumers?
  • The informative content of advertising is clear,
    when the advertisement contains direct
    information as to the existence, location,
    function or price of a product.
  • But what about all of the advertising that does
    not contain direct information of this kind? Is
    it persuasive?
  • Nelson argues rather that such advertising still
    plays an informative role, although the role is

Signaling as Information
  • To develop this argument, Nelson (1970) makes a
    distinction between search and experience goods.
  • Recall, a search good is one whose quality can be
    determined prior to purchase (but perhaps after
    costly search),
  • The quality of an experience good can be
    evaluated only after consumption occurs.
  • Indirect information contained in advertising is
    especially important for experience goods.

Signaling as Information
  • 3 reasons why advertising may provide indirect
    information about experience goods.
  • Signaling-efficiency effect.
  • The demand expansion that advertising induces is
    most valuable to efficient firms,
  • By advertising, a firm signals that it is
    efficient, which implies in turn that it offers
    good deals.

Signaling as Information
  • Match-products-to-buyers effect.
  • Consumers may have heterogeneous tastes, and it
    may be difficult to efficiently match products
    and buyers.
  • A seemingly uninformative ad can assist in this
    process, since a firm has the incentive to direct
    its advertising toward the consumers that value
    its product the most.

Signaling as Information
  • Repeat-business effect.
  • Ads may remind consumers of their previous
    experience with the product, and such
    recollections are of more value to sellers of
    high-quality goods.
  • Even new consumers may draw a positive
    association between advertising and quality, and
    advertising thus may signal quality.
  • Similar to Memory Jamming View

Signaling and Search Products
  • Ads can provide indirect information here as
  • Recall signaling-efficiency effect even if a
    search good advertisement contains no direct
    information, the fact that the good is advertised
    may suggest that the seller is efficient
  • However, search goods offer greater potential for
    direct information transmission through
  • I.e., ads for experience qualities is dominantly
    indirect information and advertising for search
    qualities is dominantly direct information

Evidence of the Signaling Theory
  • Advertising intensity is higher for experience
  • The ratio of TV to magazine advertising is
    significantly higher for experience goods
  • Search goods are especially conducive to the
    transfer of direct information
  • Advertising intensity is higher for non-durable
    experience and lower-priced experience goods
  • For major purchases, a consumer relies more on
    WOM, whereas for more frequent, low-cost
    purchases, a consumer relies on advertising as a
    source of indirect information

Memory Jamming View of Advertising
Memory Jam
  • Why do familiar brands such as Coca-Cola and
    McDonalds advertise so heavily?
  • With the average American drinking 10 gallons of
    Coca-Cola each year, its hard to believe there
    is much left for most consumers to learn about
    whats inside the can.
  • Advertising might also influence the way
    consumers encode and recall their consumption

Memory Jam
  • Psychological studies show that people can quite
    easily forget the origin of a memory.
  • E.g. the strangers face is familiar, the
    individual cannot remember why.
  • When people dont directly recall the source of a
    memory, they use what they know to fill in the

Memory Jam Experiment
  • Researcher gave participants orange juice spiked
    with salt and vinegar.
  • Results showed that people who watched
    advertisements for the juice after the taste test
    remembered the juice as tasting good.
  • Even though what they actually consumed was
    designed to taste terrible.
  • Ads changed recollection of the sensory
    experience of tasting the juice, even in the very

Memory Jamming View Formalized
  • Economic theory of advertising based on limited
    consumer memory
  • Consumers learn through experience how much they
    enjoy consuming a firms product
  • Each consumer stores in memory the utility he has
    received from consuming the product during each
    past experience
  • At the point of purchase, the consumer recalls
    the utility of these experiences to memory

Memory Jamming View Formalized
  • The firm can use advertising to change the
    likelihood that the consumer will remember a
    favorable consumption experience
  • Consistent with a large literature in the
    psychology of memory

Example Breakfast Cereal Industry
Memory Jamming
  • Average preschooler sees 642 ads/year on TV
  • Memorable slogans
  • Lucky Charms Theyre magically delicious!
  • Paired with creative cartoons- easily recall
    figures and mascots

Student Example
  • Soft Drink Industry

  • Need for the players to advertise heavily
  • Reminds the experience more than what is inside
    the can
  • Changes the way a consumer remembers an
  • Coca-Colas main type of advertising

Combative Advertising
  • Combative advertising, a characteristic of mature
    markets, is defined as advertising that shifts
    consumer preferences towards the advertising
    firm, but does not expand the category demand.
  • Not about influencing the consumer preferences,
    but rather about the supply side and advertising
  • Redistributes consumers among brands. If the real
    differences between brands are modest, then
    combative advertising may be excessive
  • Basis of Prisoner's dilemma in advertising

Prisoner's Dilemma
Advertising Wars
  • The prisoner's dilemma applies to advertising
  • All firms advertising tends to equalize the
  • Everyone would gain if no one advertised
  • Advertising Wars Two firms spend millions on TV
    ads to steal business from each other. Each
    firms ad cancels out the effects of the other,
    and both firms profits fall by the cost of the

Cigarette Advertising on TV
  • All US tobacco companies advertised heavily on TV
  • Surgeon General issues official warning
  • Cigarette smoking may be hazardous
  • Cigarette companies fear lawsuits
  • Government may recover healthcare costs
  • Companies strike agreement
  • Carry the warning label and cease TV advertising
    in exchange for immunity from federal lawsuits.

Strategic Interaction
  • Players Reynolds and Philip Morris
  • Strategies Advertise or Not Advertise
  • Payoffs Companies Profits
  • Strategic Landscape
  • Each firm earns 50 million from its customers
  • Advertising costs a firm 20 million
  • Advertising captures 30 million from competitor
  • How to represent this game?

Representing a Game
What to Do?
  • If you are advising Reynolds, what strategy do
    you recommend?

Solving the Game
  • Best reply for Reynolds
  • If Philip Morris advertises
  • If Philip Morris does not advertise

  • A strategy is dominant if it
    outperforms all other choices
    no matter what opposing players do
  • Games with dominant strategies are easy to play
  • No need for what if thinking

Dominance A Technical Point
  • Strict Dominance
  • Advertise is strictly dominant for Reynolds if
  • Profit (Ad , Ad) gt Profit (No , Ad)
  • Profit (Ad , No) gt Profit (No , No)

COMMANDMENT If you have a dominant strategy, use
it. Expect your opponent to use her dominant
strategy if she has one.
Prisoners Dilemma
  • Both players have a dominant strategy
  • The equilibrium results in lower payoffs
    for each player

Equilibrium Illustration
  • The Lockhorns

Cigarette Advertising
  • After the 1970 agreement
  • Cigarette advertising decreased by 63 million
  • Industry Profits rose by 91 million
  • Prisoners Dilemma
  • An equilibrium is NOT necessarily efficient
  • Players can be forced to accept mutually bad
  • Bad to be playing a prisoners dilemma, but good
    to make others play

Empirical Studies of Advertising Effectiveness
AdvertisingSales Relationship
  • Lambin (1976) uses various sales, quality, price
    and advertising data
  • 107 individual brands from
  • 16 product classes
  • 8 different Western European countries
  • How changes in the advertising expenditures for
    one brand may affect the current sales of that
    brand and rival brands?
  • Evaluate goodwill effects and the rival-brand
    response that an advertising expenditures may

Lambin (1976) Findings
  • Brand advertising has a significant and positive
    effect on the brand's current sales and market
  • Evidence for advertising's goodwill effect
  • The quantitative impact of advertising on
    (current and future) sales is limited
  • Sales appear more responsive to price and
    product-quality selections
  • Firm's sales and market share are negatively
    related to rival advertising
  • Evidence of what?

Advertising Goodwill
  • Clarke (1976) identifies a data-interval-bias
  • The use of annual advertising data when the
    effects of advertising on sales depreciate over a
    shorter period of time can lead to biased
    estimates of the depreciation rate.
  • The duration of cumulative advertising effect on
    sales is between 3 and 15 months thus this
    effect is a short-term (about a year or less)
  • More recently, several studies offer further
    evidence that the effect of advertising on sales
    is often largely depreciated within a year (if
    not less).
  • Latest studies Beyond 3 months miniscule

Sales Response Models
Saturation Point
Sales Response Model
Saturation Effect
Adv Expenditures
Threshold Effect
Overall Advertising Impact (Gerard J. Tellis)
  • The average sales-to-advertising elasticity is
  • Higher for new products than established products
  • For Europe than the United States
  • For durables than nondurables
  • For print than TV
  • Advertising elasticity is also lower in models
    that use disaggregate data and include
    advertising carryover, quality, or promotion

Determinants of Advertising Impact (Demetrios
  • Advertising impact depends on the product
  • Specifically, advertising elasticities are as
    much as 50 higher for durables as for
  • Advertising is more effective for experience than
    for search products.

Advertising Impact and Competition (Demetrios
  • Higher competitive intensity (clutter) will
    result in lower advertising effectiveness.
  • Competitive advertising may reduce elasticities
    by as much as 50.

Advertising Reference Price (Dhruv Grewal and
Larry D. Compeau)
  • The presence of an advertised reference in a
    price offer enhances perceptions of value
  • Lowers their intention to search for a lower

Advertising Impact Duration (Robert P. Leone)
  • The average advertising duration interval on
    sales is brieftypically between six and nine

TV Advertising Effect
  • The average TV advertising to sales elasticity is
    0.11 for established consumer products.
  • It is higher for tests after 1995 than those
  • There is a high variability in effects around
    these average elasticities. Some tests had
    elasticities over 0.5 and others were below -0.05.

Advertising and Business Cycles
  • Advertising is more sensitive to business-cycle
    fluctuations than the economy.
  • Average co-movement elasticity is1.4.
  • Hence, a 1 increase in the cyclical component of
    GDP translates, on average, into a 1.4 increase
    in the cyclical component of the demand for
  • The extent of this sensitivity varies
    systematically across countries.
  • When companies tie advertising spending too
    tightly to business cycles, they experience
    higher losses
  • A lower long-term growth of the advertising
  • A higher private-label share
  • Lower stock prices

Empirical Studies
  • A firm's current advertising is associated with
    an increase in its sales, but this effect is
    usually short lived.
  • Advertising is often combative in nature.
  • An increase in advertising by one firm may reduce
    the sales of rival firms, and rivals may then
    react with a reciprocal increase in their own
    advertising efforts.
  • The overall effect of advertising on primary
    demand is difficult to determine and appears to
    vary across industries.

Firm Specific Factors
  • When assessing the goodwill impact of
    advertising, it is important that firm-specific
    factors not be omitted.
  • Recall Nelsons theory
  • It may be that advertising affects initial sales
    but that long-term sales are driven by
    firm-specific factors, like product quality.
  • Given that higher-quality firms may advertise
    more, the effects of advertising on future sales
    may be overstated in an empirical analysis that
    omits product quality.
  • Kwoka (1993) examines the determinants of model
    sales in the U.S. auto industry, finding that the
    effect of advertising is short-lived while
    product styling has a much longer impact.

Advertising and Entry
  • Advertising as a response of incumbent firms to
  • Alemson's (1970) studies Australian cigarette
    industry new entrants advertise to gain market
    share and induce increased advertising by
    incumbents, who seek to maintain market share.
  • Thomas (1999) studies the ready-to-eat cereal
    industry and reports that incumbent firms often
    respond to entry with advertising, in order to
    limit the sales of new entrants.
  • Cubbin and Domberger (1988) examine 42
    consumer-goods industries and report evidence
    that dominant incumbent firms in slow-growth
    markets often respond to entry with an increase
    in advertising.

Advertising and Industry Demand
  • Empirical studies suggest that advertising may
    increase primary demand in some industries but
    not others.
  • Positive relationships between industry
    advertising and sales
  • UK cigarette industry
  • U.S. cigarette industry
  • U.S. orange market
  • U.S. auto industry
  • No effect
  • U.S. beer market
  • UK instant-coffee market

Advertising and Brand Loyalty
  • No clear consensus.
  • The studies do not provide strong evidence that
    advertising consistently increases brand loyalty
    or stabilizes market shares.

Brand Loyalty
  • Recall Persuasive view
  • The direct effect of advertising is that brand
    loyalty is created and the demand for the
    advertised product becomes less elastic.
  • Lack of high detail data need exposure and
    brand-purchase data as well as the advertising
    and pricing behaviors of rival firms.
  • Partly remedied by advent of supermarket scanner
  • 2 ways to test for brand loyalty
  • Estimate demand functions for individual brands,
    in order to see if consumers exhibit more
    inertia in highly advertised markets.
  • See if the estimated price elasticities are lower
    in magnitude in product groups with high
    advertising intensity.
  • Infer the extent of brand loyalty, by further
    examining the relationship between advertising
    and market-share stability.

Advertising Costs and Media
Media Selection
  • Coverage is the theoretical maximum number of
    consumers in the retailers target market that
    can be reached by a medium and not the number
    actually reached.
  • Reach is the actual total number of target
    customers who come in contact with an advertising
  • Cumulative Reach is the reach that is achieved
    over a period of time.

Media Selection
  • Frequency is the average number of times each
    person who is reached is exposed to an
    advertisement during a given time period.

When High Frequency Is Used
  • A new brand
  • A smaller, less known brand
  • A low level of brand loyalty
  • Relatively short purchase and use cycle
  • With less involved (motivated and capable) target
  • With a great deal of clutter to break through

Media Selection
  • Cost Per Thousand Method (CPM) is a technique
    used to evaluate advertisements in different
    media based on cost.
  • The cost per thousand is the cost of the
    advertisement divided by the number of people
    viewing it, which is then multiplied by 1,000.

Media Selection
  • Cost Per Thousand Target Market (CPM-TM) Is the
    cost of the advertisement divided by the number
    of people in the target market viewing it, which
    is then multiplied by 1,000.
  • Impact refers to how strong an impression an
    advertisement makes and how well it ultimately
    leads to a purchase.

  • Cost measured per thousand impressions (CPM)?
  • Broadcast TV 10 CPM for 30 second impr
  • Superbowl 30 second spot 25-40 CPM
  • Around 1 cent per 30 sec impression 2 cents for
    1 minute 20 cents for 10 minutes
  • Conclusion TV network is paid 20 cents an hour
    of content for your attention

Typical CPMs
  • Outdoor 1-5 CPM
  • Cable TV 5-8 CPM
  • Radio 8 CPM
  • Online
  • Display 5-30 CPM
  • Contextual 1-5 CPM
  • Search 1 to 200 CPM
  • Network/Local TV 20 CPM
  • Magazine 10-30 CPM
  • Newspaper 30-35 CPM
  • Direct Mail 250 CPM

Network TV CPMs
  • CSI 19.59
  • Without a Trace 13.83
  • CSI Miami 17.30
  • Desperate Housewives 11.81
  • Everybody Loves Raymond 25.19

Gross Rating Points
  • GRPs Reach X Frequency.
  • GRPs measure the total of all Rating Points
    during an advertising campaign.
  • A Rating Point is one percent of the potential
    audience. For example, if 25 percent of all
    targeted televisions are tuned a show that
    contains your commercial, you have 25 Rating
  • If, the next time the show is on the air, 32
    percent are tuned in, you have a total of 25 32
    57, and so on through the campaign.

Media Tactics
  • Three ways to schedule the same number of GRPs
  • Continuous
  • Flighting
  • Pulsing

Selling Network Television
  • The Upfront Market
  • The Scatter Market
  • The Opportunistic Market

Television Sells Spots Like Airlines Sell Seats
  • If a flight leaves with empty seats, revenue for
    the seat is zero.
  • To assure full planes, sell the seats at a price
    that will sell them out early.
  • Charge last -minute buyers highest price

  • Annual purchase of commercial time well in
    advance of the telecast time.
  • Upfront advertisers buy 70 of prime time and 50
    of other dayparts. Most buy for one year. Get
    best price.
  • Biggest national advertisers buy childrens
    programs, prime time, daytime, news, and late

  • Sale of most of the years remaining inventory
    not sold at upfront.
  • Inventory generally tight.
  • Prices usually 50 higher than upfront.

  • Last-minute buying of inventory due to
  • Changes in programming
  • Advertisers dont want to be on controversial
  • Advertiser inability to pay

Cancellations and Guarantees
  • Most network orders are non-cancelable. If an
    advertiser cannot or does not want the time, it
    is the advertisers responsibility to sell the
    time - not the networks.
  • Networks cancel programs with no notice to the
    advertiser with the provision that commercials
    will run in another program that delivers the
    same audience profile.

Ratings Guarantees
  • The cost of network time is based on network
    guarantees of spot price vs. audiences, computed
    in cost per thousand.
  • If the ratings projected by the network to the
    advertiser are not achieved, the network runs
    the spot in other programs to accumulate
    sufficient ratings to bring the CPM down to the
    promised level.
  • The extra spots the advertiser gets are called